Macroeconomics: Spring 2009 Notes Chapter 12 – Expenditure Multipliers: The Keynesian Model Fixed Prices and Expenditure Plans Keynesian Model (In Chap. 12) – describes econ. in very SR; isolates and places in focus the forces that operate at a business cycle peak, when expansion ends and a recession begins, and a trough, when a recession turns into an expansion With this type of model, all firms are like a local supermarket (in the short term their prices are fixed); firms hold the prices they have set, the Q they sell depend on D not S Fixed prices have 2 immediate implications for the economy as a whole: Since each firm’s price is fixed, the price level is fixed Since D determines the quantities that each firm sells, AD determines the aggregate Q of goods and services sold, which = real GDP Expenditure Plans (Aggregate; also sum to Real GDP) Consumption expenditure (depends on Real GDP b/c it depends on income) Investment Gov’t expenditure on goods and services Net Exports (exports – import Aggregate planned expenditure – equal to planned consumption expenditure plus planned investment plus planned gov’t expenditure on goods and services plus planned exports minus planned imports An increase in real GDP increase aggregate expenditure An increase in aggregate expenditure increases real GDP Consumption Function and Saving Function Factors that influence consumption expenditure and saving: Disposable Income – aggregate income minus taxes plus transfer payments; depends on real GDP or net taxes (depends means changed because of) Real interest rate, wealth, expected future income (when constant focus on relationship b/w consumption expenditure and disposable income) Consumption and Saving Plans Planned consumption expenditure plus planned saving ALWAYS = disposable income Consumption function – relationship b/w consumption expenditure and disposable income, other things remaining the same Saving function – relationship b/w saving and disposable income, other things remaining the same Autonomous consumption – amount of consumption expenditure that would take place in the short run even if people had no current income Induced consumption – expenditure that is induced by an increase in disposable income 45 Degree Line – At each pt. of the line the consumption expenditure = disposable income; above the line means consumption expenditure exceeds disposable income; under the line means that consumption expenditure is less than disposable income Saving Function – when disposable income increases, so does saving and vice versa; negative saving is save dissaving; when disposable income exceeds consumption expenditure saving is (+), when consumption expenditure equals disposable income saving is 0 Marginal Propensities to Consume and Save – both added together ALWAYS = 1 Marginal propensity to consume (MPC) – is the fraction of a change in disposable income that is consumed. Calculated as the change in the consumption expenditure/ change in disposable income that brought it about Marginal propensity to save (MPS) – is the fraction of a change in disposable income that is saved. Calculated as the change in saving/ the change in disposable income that brought it about Slope and marginal propensities – slope of consumption function is the marginal propensity to consume; slope of saving function is marginal propensity to save Other influences on consumption expenditure and saving – real interest rate falls or wealth/expected future income increases, consumption expenditure increases and savings decreases(usually occurs during expansion of phase of business cycle); when opposite occurs is causes consumption expenditure to decrease and savings to increase(usually occurs during a recession) Import Function – influenced by real GDP in the SR(the greater the GDP the greater the # of imports); Marginal propensity to import – fraction of an increase in real GDP that is spend on imports; Calculated as the change in imports/change in real GDP The Multiplier - the amount by which a change in autonomous expenditure is magnified or multiplied to determine the change in eq’m expenditure and real GDP The Basic Idea of the Multiplier An increase in investment (or any autonomous expenditure) increases aggregate expenditure and real GDP Increase in GDP leads to increase in induced expenditure; the increase in induced expenditure leads to a further increase in aggregate expenditure and real GDP Thus, real GDP increases by more than the initial increase in autonomous expenditure Brings unplanned decrease in inventories, so firms increase prod and real GDP increase to new e’qm Multiplier effect – amplified change where the eq’m expenditure increases by more than the increase in the autonomous expenditure. The multiplier is greater than 1 Why is the multiplier higher than 1? Because an increase in autonomous expenditure induces further increase in aggregate expenditure The size of the multiplier Change in eq’m expenditure/change in autonomous expenditure The multiplier and the slope of the AE curve (which determines the magnitude of the multiplier) Multiplier = 1/(1-slope of AE curve) or multiplier = change in real GDP/change in auto exp. The steeper the large the multiplier; agg. Expenditure and real GDP change b/c induced and autonomous expenditure change. Change in real GDP = change in autonomous and induced exp. But the change in induced expenditure is determined by the change in real GDP and the slope of the AE curve : Slope of AE curve = change in induced exp/ change in real GDP When there are no income taxes or imports the slope of AE = the Marginal propensity curve Imports and Income Taxes (make multiplier smaller) Increase in investment increases real GDP and consumption exp; but only exp on US goods will increase US real GDP(b/c some exp is on imports) When income taxes increases, disposable income increases by less than the increase in real GDP; thus consumption expenditure increase by less than if the taxes did not change; the larger the tax rate the lower the disposable income and real GDP The marginal propensity to import and income tax rate together with the marginal propensity to consume determine the multiplier; combined influences determines slope of AE; initial change in autonomous expenditure leads to magnified change in agg. Exp. and real GDP The Multiplier Process - the MPC determines the magnitude of the amount of induced expenditure at each round as aggregate expenditure moves toward eq’m expenditure Business Cycles – forces include swings in auto. exp. such as investment and exports Increase in auto exp brings an unplanned decrease in inventories, triggers expansion Decrease in auto exp brings an unplanned increase in inventories, triggers recession